2014 Year-End Securities Enforcement Update

January 12, 2015

The close of 2014 saw the SEC’s Division of Enforcement take a victory lap. Following the release of the statistics for the fiscal year ended September 30, Division Director Andrew Ceresney touted a few records — the largest number of enforcement actions brought in a single year (755); the largest total value of monetary sanctions awarded to the agency (over $4 billion); the largest number of cases taken to trial in recent history (30).[1] As Ceresney noted, numbers alone don’t tell the whole story. And it is in the details that one sees just how aggressive the Division has become, and how difficult the terrain is for individuals and entities caught in the crosshairs of an SEC investigation under the current administration.

The SEC has continued to roll out a steady flow of settlement agreements under which defendants are compelled to admit their legal violations. The Division has increased the number of litigated actions pursued in the administrative forum, where defendants enjoy far fewer rights than in civil district court actions. The size of monetary sanctions and the length of industry bars continue to rise. And the Division has been executing the Chair’s "broken windows" policy, filing suit to enforce even minor, rarely-enforced provisions of the federal securities laws, often in broad sweeps targeting dozens of defendants (a phenomenon which may help explain the record number of cases brought last year).

Substantively, the Division has maintained its focus on the investment advisor industry (particularly private fund managers), as well as brokers and financial institutions. Meanwhile, the Division’s renewed scrutiny of financial reporting by public companies — which saw a significant slowdown in activity during the years of the financial crisis — continues its slow but steady return to the forefront, with several accounting fraud cases drawing headlines in recent months.

Before turning to our analysis of significant case developments from the past six months, we will address some of the overriding enforcement trends from the past year.

I. Significant 2014 Developments

A. The AP Explosion

Our Mid-Year Securities Enforcement Update addressed the SEC’s growing use of administrative proceedings (APs) as an alternative to civil actions filed in federal court.[2] As noted above, the SEC is litigating an increasing number of cases (arguably stemming in part from its hardline settlement demands), and the streamlined administrative proceeding process, with cases lasting months rather than years, helps the agency conserve limited resources. But the forum can also work to the disadvantage of defendants.

Among other things, there is little or no discovery in these proceedings, meaning defendants are essentially limited to whatever evidence the enforcement staff collected during its investigation. Defendants who lose in front of the administrative law judge (employed by the SEC) face an uphill battle on appeal, with any appeal first heard by the SEC itself (i.e. the very Commissioners who originally voted to authorize the enforcement action), and only later by a federal court of appeals, which tends to be deferential to agency determinations.

Moreover, many believe these proceedings offer the Division of Enforcement a home court advantage. Indeed, a Wall Street Journal study this fall found the Division had a 100% success rate in administrative proceedings over the past twelve months — not exactly encouraging for parties choosing to litigate against the agency.[3] In contrast, as Ceresney noted in his November Speech, the Division has about an 80% success rate in litigated actions overall, suggesting far more trial losses for the agency in federal court.[4]

Notwithstanding pushback on these proceedings by the defense bar and some commentators, including repeat SEC critic Judge Rakoff of the Southern District of New York,[5] the SEC has stood by the continued use of the administrative forum. In his November Speech, Ceresney vigorously defended the fairness and utility of the administrative forum in a lengthy discourse, noting that the agency filed 43% of its litigated cases administratively in 2014 and had no intentions of reversing course. Indeed, in late 2014 the SEC took steps to prepare for the increased administrative caseload, adding two new administrative law judges, bringing the total to five.

Several parties to SEC administrative proceedings have sued the agency in federal court, alleging such proceedings, among other things, violate their Due Process rights; however, these challenges have been largely unsuccessful. In the most recent ruling, a New York federal court dismissed the action, holding that while defense concerns about administrative proceedings may be legitimate, they needed to be resolved in the administrative proceeding itself — and, if unsuccessfully asserted there, on subsequent appeal of the administrative law judge’s decision, rather than in a stand-alone injunctive action against the SEC.[6] Hence, while several similar cases remain pending, it appears that it will be some time — perhaps years — before an appropriate challenge to administrative proceedings becomes ripe for resolution. In the interim, parties to SEC investigations need to anticipate a growing likelihood that an enforcement action will be filed administratively, and prepare in advance for the abbreviated timeframe and limited discovery of such proceedings.

B. Sweeping Up "Broken Windows"

In late 2013, SEC Chair Mary Jo White proclaimed a "broken windows" strategy of enforcing even minor, frequently overlooked violations, underscoring that it was "important to pursue even the smallest infractions."[7] The Division of Enforcement made good on this commitment in the latter half of 2014, bringing a number of enforcement "sweeps" in which it simultaneously charged multiple companies and individuals with violations of non-fraud securities law provisions not historically viewed as high-priority by the agency. All told, 5 sweeps in the last few months entangled 80 defendants.

In September, the SEC charged 34 companies and individuals with failing to timely file personal securities transaction reports with the SEC.[8] Of the 34 respondents named in the orders, 33 settled the claims and agreed to pay financial penalties in the aggregate amount of $2.6 million. These securities law provisions — Sections 13(a) and 16(a) of the Exchange Act and related rules — had rarely been the subject of stand-alone enforcement actions in the past decade, typically appearing (if at all) as part of larger, more serious cases. But the SEC set out to highlight its focus on even lesser, unintentional violations, noting that "inadvertence is no defense to filing violations, and we will vigorously police these sorts of violations through streamlined actions."[9]

One week later, the Commission charged 19 investment advisory firms (and one individual trader) for violations of Rule 105 of Regulation M of the Exchange Act, which prohibits short-selling an equity security shortly before participating in an offering of the same security.[10] Each of the respondents agreed to settle the charges, cumulatively paying more than $9 million in disgorgement and penalties. This was the SEC’s second Rule 105 sweep, following a prior action almost exactly one year earlier which had netted an additional 23 firms.

In November, venturing into the muni bond arena, the SEC sanctioned 13 securities dealers for selling non-investment grade bonds issued by the Commonwealth of Puerto Rico to customers below the minimum denomination of the issue, in violation of Municipal Securities Rulemaking Board (MSRB) rules.[11] The sweep represented the SEC’s first enforcement action under this MSRB provision. The firms paid penalties ranging from under $55,000 to $130,000.

Later that same week, the SEC initiated settled enforcement actions against 10 small public companies for failing to file a Form 8-K disclosing financing arrangements or other unregistered securities sales that had the effect of diluting the company’s stock.[12] The companies agreed to pay penalties ranging from $25,000 to $50,000.

Finally, in December, the SEC initiated settled proceedings against eight small accounting firms for violating auditor independence rules in connection with their audits of brokerage firm clients.[13] According to the SEC, the auditors also participated in the preparation of their respective clients’ financial statements, improperly playing the role of both preparer and auditor. A total of $140,000 in penalties was assessed.

The Division of Enforcement is clearly enthusiastic about these sweeps, and likely to initiate more in 2015. The cases give the SEC an opportunity to send a "message" about aggressive enforcement of the securities laws, even the low-level "broken windows" offenses championed by the Chair, while allowing the Division of Enforcement to announce record-breaking case filings without the same resource expenditures as individual investigations. Moreover, the sweeps put defendants in a difficult position; by focusing on strict-liability or negligence-based violations with limited defenses, and setting penalty thresholds that are significant but still lower than typical litigation costs, most defendants have little choice but to accept a settlement. Notably, at least one Commissioner has expressed some concern about the broken windows strategy, urging the agency to instead focus on higher priority issues.[14]

With no guidance as to where the next SEC sweep may land, participants in securities markets need to be attuned to compliance with even low-level, rarely-enforced securities regulations, complicating efforts to have a more risk-based compliance program prioritizing more serious issues.

C. Financial Fraud Is Back, Maybe…

Since assuming their leadership positions in 2013, Chair White and Enforcement Director Ceresney have touted the agency’s renewed focus on public company reporting. With resource-intensive financial crisis-related investigations largely wound down, the SEC has demonstrated an eagerness to expand its forays back into financial reporting matters, most notably with the creation of a dedicated Financial Reporting and Audit Task Force.[15] The SEC is now proactively looking for potential financial fraud, rather than waiting for self-reporting by issuers on the cusp of a restatement, and allocating resources to probing even the smallest companies and lesser violations. Of course, it is an open question whether there is a groundswell of fraud waiting to be found by the agency; the jury is still out on whether the dramatic decline in financial fraud cases in recent years reflected the SEC’s failure to find them (perhaps due to a redirection of limited resources into other areas), or a reduction in misconduct by public companies (either because of improved practices in the years after Sarbanes-Oxley, or simply cyclical market forces that reduced the incentives for earnings management during a financial downturn).

It is too soon to judge the impact of the Division’s new efforts. However, the sense among practitioners is that the agency is opening a growing number of financial reporting investigations, and we did see an apparent uptick in accounting fraud cases in recent month, including several revenue recognition matters. (See discussion of cases below.) While the cases to date have been on the small end of the spectrum, and a far cry from the accounting scandals of the Enron/Worldcom era, there are some hints of larger cases on the horizon. For example, in the closing days of 2014, one public company disclosed that it had reached a tentative agreement with the SEC staff, still awaiting Commission approval, under which the company, without admitting wrongdoing, would pay a $190 million penalty. If approved, this would be a significant penalty for a non-FCPA, non-financial institution case.

That said, the always-controversial issue of corporate penalties is likely to re-emerge as a point of contention. During the stock option backdating scandal several years ago, divisions arose among Commissioners as to whether assessing penalties against public companies was a necessary tool to deter fraud, or an unfair cost borne by the company’s shareholders. The SEC adopted guidelines on corporate penalties in 2006 designed to provide greater rigor around the penalties, though some saw the guidelines as making it more difficult for the Enforcement staff to seek penalties at all.[16] The debate quieted down in recent years with the fall-off in public company fraud cases, but will undoubtedly return as more such cases are brought. Chair White is on record as defending such penalties, noting that "we must make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties — whether against companies or individuals — play a very important role in a strong enforcement program."[17] In contrast, Commissioner Piwowar, in an October 2014 speech, expressed concerns about corporate penalties, and urged at minimum closer adherence to the 2006 guidelines.[18] His fellow Republican appointee, Commissioner Gallagher, was even blunter, referring to corporate penalties as "shareholder penalties."[19]

D. Whistleblowers Cash In

The second half of 2014 featured several significant landmarks for the SEC’s whistleblower program, offering critical reminders to companies of the risks posed by the post-Dodd-Frank bounty system. In September, the agency announced its largest whistleblower award since the program’s 2012 inception–$30 million to be paid to a single individual.[20] This more than doubled 2013’s previous record of $14 million. Because of the requirement that information about whistleblowers be kept confidential, the SEC did not disclose the nature of the case, but did note that the whistleblower lives outside the United States, and that the award could have been even higher but for the whistleblower’s "unreasonable" delay in reporting the violations.[21]

The SEC also reported awards in two cases where the whistleblower had previously reported concerns internally, and reached out to the SEC only when the matter was not addressed by the company. In July, the SEC awarded $400,000 to a whistleblower, noting that "[t]he whistleblower had tried on several occasions and through several mechanisms to have the matter addressed internally at the company."[22] And in August, the SEC announced a $300,000 award to a whistleblower who "reported concerns of wrongdoing to appropriate personnel within the company," but "when the company took no action on the information within 120 days, the whistleblower reported the same information to the SEC."[23] Significantly, the latter case was the first award made to an employee serving an audit or compliance function at a company.

The SEC’s 2014 Annual Report on the whistleblower program, issued in November, highlighted the continuing growth in importance of whistleblowers to the SEC. The number of whistleblower tips rose to 3,620 in fiscal 2014 from 3,238 the prior year.[24] Corporate disclosures and financials continued to be the leading category of complaints (at about 17%), aligning with the Division of Enforcement’s growing focus on public company reporting cases.

E. Admissions

Finally, the SEC’s policy of selectively seeking admissions of wrongdoing as a condition of settlement, implemented in mid-2013 in the wake of public (and judicial) criticism of the agency’s long-standing policy of settling cases with defendants neither admitting nor denying the SEC’s allegations, remains in full force. As promised by Enforcement Director Ceresney, admissions have been required infrequently, in just over a dozen cases to date, with the vast majority of SEC settlements continuing to be resolved on a neither-admit-nor-deny basis. However, contrary to earlier suggestions, it does not appear that admissions have been limited to the most egregious securities law violations. Indeed, in 2014, several of the world’s largest financial institutions settled SEC actions with admissions of wrongdoing where the SEC did not allege scienter-based violations or even fraud.

It is thus difficult to predict in which cases the Division of Enforcement will demand party admissions. While egregiousness and investor harm may be factors, many of these settlements appear to involve situations where, as Ceresney has explained, "admissions would significantly enhance the deterrence message of the action."[25] As a practical matter, this appears to be based in part on the size and name-recognition of the settling party. One thing the Division has made clear, though, is that whether an admission will be required as part of the settlement is wholly at the discretion of the SEC and not subject to negotiation.[26]

II. Public Company Reporting & Accounting

A. Financial Fraud and Internal Controls Cases

As noted above, the SEC has been stepping up its focus on public company accounting, and while 2014 did not see any cases approaching the magnitude of the Worldcom/Enron era a decade ago, the agency did bring a number of relatively smaller cases, including several traditional revenue recognition cases, which had become somewhat scarce in recent years. The SEC leveled charges ranging from scienter-based fraud to failures to maintain adequate internal controls, at times without clear guidance as to what drove the charging decision. The most striking example of this can be seen in a pair of software company cases filed a day apart in September.

On September 24, the SEC filed a case against Silicon Valley software company Saba Software and two of its vice presidents, alleging that they had directed consultants in India to "pre-book" hours they had not worked to achieve their quarterly revenue targets and to "under-book" hours when they had overrun their budgets.[27] The SEC’s administrative order included charges of fraud as well as falsification of books and records and overriding internal controls. Without admitting or denying the allegations, the company and the two individuals agreed to settle the matter by paying penalties of $1.75 million, $85,017 and $69,621 respectively. Notably, the SEC also filed a clawback action against the Company’s CEO, requiring him to reimburse the company for $2.5 million in bonuses and stock sale proceeds, even though it did not charge him with any securities law violations. While Sarbanes-Oxley authorized the SEC to pursue such stand-alone clawback actions, and the courts have upheld the ability of the SEC to do so even in the absence of underlying charges[28], such actions are exceedingly rare, pursued only a handful of times since the passage of SOX in 2002.

One day later, the SEC filed a similar action against an Arizona software company, JDA Software Group, alleging violations of the identical GAAP provisions based on the company’s improper timing of revenue recognition.[29] Yet the JDA Software case resulted only in internal controls claims, and no charges were brought against individual corporate officers. (Notwithstanding the absence of fraud charges, the company still agreed to pay a $750,000 penalty, itself an indicator of the SEC’s aggressive settlement stance even in non-fraud matters.) The respective Saba Software and JDA Software orders give little guidance as to why fraud charges were pursued by the SEC in the former case but not the latter (though the JDA order does call out the company’s remedial actions and cooperation with the investigation).

The SEC also leveled fraud charges in another revenue recognition case. In August, the SEC filed charges against AirTouch Communications Inc. and its former CEO and CFO for recording as revenue approximately $1.24 million worth of inventory that was purported shipped to a company that agreed to store the products but had not purchased the inventory.[30] The case also serves as a prime example of the phenomenon discussed earlier: The SEC filed the action as a litigated administrative proceeding.

Likewise, the SEC saw an increased willingness to pursue stand-alone internal controls cases even absent fraud charges, whereas in the past the SEC might have opted to overlook such matters and focus its resources on more egregious violations. For example, in October, the SEC imposed sanctions of $150,000 on Great Lakes Dredge & Dock Corporation for recording as revenue pending change orders without sufficient proof of customer acceptance of the orders.[31] And in December, the Commission brought settled charges against a bank holding company and its former CFO for improperly accounting for a deferred tax asset resulting in the entity materially understating its losses.[32]

And in a somewhat unusual hybrid case, the SEC charged the former CEO and CFO of Florida equipment company QSGI Inc. with fraud for making false statements about the adequacy of the company’s internal controls.[33] According to the SEC, the executives misrepresented the scope of the CEO’s participation in management’s assessment of its internal controls, and withheld information about deficient inventory controls from the company’s auditors. The SEC charged antifraud violations as well as bringing books and records and internal controls claims. The SEC settled with the CFO, and is litigating against the CEO (again, in an administrative proceeding rather than in federal court).

The SEC’s filing of non-fraud internal controls actions drew some noteworthy criticism. In a rare move, SEC Commissioner Luis A. Aguilar issued a scathing public dissent from the SEC’s vote to institute settled non-fraud proceedings against a public company’s CFO. In the SEC’s August case against the former CEO and CFO of Affiliated Computer Services, the agency alleged that the company improperly reported $124.5 million in revenue by having an equipment manufacturer re-direct pre-existing customer orders to the company, creating the appearance that ACS had been involved in the transactions.[34] Without admitting or denying the allegations, the executives agreed to collectively disgorge $569,327 in bonuses, and to each pay $52,000 in penalties. Commissioner Aguilar denounced the settlement with the CFO for failing to include fraud charges or suspending him from appearing before the agency as an accountant under Rule 102(e).[35] Calling the conduct "egregious," Commissioner Aguilar contended that the agency’s decision to bring only settled internal controls charges was "a wrist slap at best," and expressed concern that the case was "emblematic of a broader trend at the Commission where fraud charges—particularly non-scienter fraud charges—are warranted, but instead are downgraded to books and records and internal control charges."

B. Auditor Cases

While the SEC has clearly stepped up its activity in the accounting fraud arena, the last six months saw few noteworthy cases involving auditors, with just a few cases, primarily involving small accounting firms.

Auditor independence rules remained an ongoing priority for the SEC. As discussed earlier, in December 2014 the agency instituted an enforcement sweep against 8 accounting firms for preparing the financial statements of brokerage firms that they also audited. Earlier this year, the SEC initiated litigated administrative proceedings against a small public accounting firm for independence violations based on its audit of a broker-dealer which regularly traded the securities of a public company closely associated with the auditor.[36]

In October, in a continuation of its Operation Broken Gate (aimed at targeting auditors "who disregard their gatekeeper roles" by "violating professional standards"), the SEC sanctioned a Florida auditor for violating rules requiring lead audit partners to rotate off audit engagements after five years.[37] According to the SEC, the respondent installed as lead audit partner an employee who was not a certified public accountant, while continuing to perform those duties himself.

Audits of China-based companies and small oil-and-gas entities also continued to be a recurring enforcement theme. In July, the Commission instituted litigated proceedings against a Salt Lake City accounting firm and two of its partners, who served as the independent auditors of a China-based chicken company, for improperly relying on prior auditor’s work without sufficient review and failing to implement procedures that would identify known risks.[38] In September, a sole-practitioner accountant settled with the Commission and agreed to no longer appear before the SEC for his alleged failures to exercise appropriate due professional care or professional skepticism when conducting audits of a small oil-and-gas company.[39] Among other things, the SEC faulted the auditor for performing an audit of two years’ financial statements of two companies purchased by the issuer in less than two days. And in December, the SEC announced a settlement with a Hong Kong accounting firm and two of its accountants in connection with their audit of a China-based oil company, alleging that they had failed to take appropriate steps in their review of the company’s related party transactions.[40] The firm agreed to pay a $75,000 penalty, and the two individuals agreed to pay penalties of $10,000 and $20,000 and to be barred from practicing before the SEC as accountants for three years.

III. Investment Advisers and Funds

The SEC’s stepped-up focus on private fund managers surged into high gear in 2014, as the SEC’s Office of Compliance Inspections and Examinations ("OCIE") began sharing its findings emerging out of its initial examinations of hedge funds and private funds newly registered under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). These exams have been augmented by the aggressive stance of the SEC’s Enforcement Division, which filed a number of high-profile enforcement actions against private funds. Cases against investment advisers generally remain one of the largest components of the SEC’s enforcement docket (far outstripping public company accounting fraud and insider trading cases).

As discussed below, some of the hottest topics arising out of OCIE’s presence exams, and the issues most likely to garner future Enforcement interest, include expense allocation and undisclosed fees, asset valuation, and misleading marketing materials. In addition, recurring issues continue to arise out of the custody rule and inadequate (or unenforced) compliance policies.

A. Fees & Expenses

In September 2014, the SEC instituted a settled action against New York private equity firm Lincolnshire Management alleging the firm misallocating expenses between two funds it managed.[41] The two funds each owned separate companies, which the firm subsequently integrated. However, according to the SEC, Lincolnshire at times misallocated certain portfolio company expenses between its funds, or failed to document such allocations. The SEC also found that Lincolnshire failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 arising from the integration of the two portfolio companies. Lincolnshire paid nearly $1.9 million in disgorgement and prejudgment interest and a $450,000 penalty.

In a much more egregious fees case, the SEC in September 2014 charged the former fund manager of San Francisco-based hedge fund WestEnd Capital Management with defrauding fund clients by taking excess management fees from them and using their money to upgrade his multi-million dollar home and purchase a Porsche.[42] The SEC alleged that the manager wrongfully withdrew more than $320,000 from the fund, far in excess of the 1.5% of each investor’s capital account balance that was disclosed to clients as the annual management fee. The SEC also reached a settlement with the advisory firm for failing to supervise the manager (who it subsequently terminated), with WestEnd agreeing to pay a $150,000 penalty and to retain a compliance consultant.

B. Conflicts of Interest

Inadequately disclosed or addressed conflicts of interest, of perennial interest to both the SEC examination and enforcement programs, were at the center of a significant number of enforcement actions in the latter half of 2014.

In August, the SEC instituted litigated proceedings against registered investment adviser PageOne Financial and its principal, alleging that they concealed conflicts of interest from advisory clients in connection with three private investment funds they managed.[43] The SEC alleged that PageOne and its principal failed to disclose that one of the fund’s managers had agreed to acquire at least 49% of the firm, and that as part of the deal respondents had agreed to raise millions of dollars for the funds, with payments for the acquisition in part tied to PageOne’s ability to direct client money into the private funds. According to the SEC, this created a potential conflict for the objectivity of respondents’ investment advice to their clients. The SEC also alleged various misrepresentations related to the undisclosed agreement with the fund manager.

Later in August, the SEC initiated settled proceedings against hedge fund adviser Structured Portfolio Management (SPM) and two of its affiliated advisers.[44] The SEC alleged that SPM allowed a trader to trade the same securities across three SPM-managed hedge funds, creating an opportunity for the trader to engage in improper allocations. According to the SEC, the firm recognized and disclosed the potential conflict of interest that could arise, but failed to adopt written policies and procedures reasonably designed to detect and prevent improper trade allocations. Without admitting or denying the SEC’s allegations, SPM and the two affiliated advisers agreed to several undertakings and to pay a penalty of $300,000.

In September, investment advisory firm Strategic Capital Group LLC (SCG) was charged with engaging in more than 1,100 principal transactions through its affiliated broker-dealer without providing written disclosure to clients or obtaining their consent. The SEC also alleged that the firm’s CEO signed regulatory filings claiming SCG did not engage in principal transactions, and that the firm failed to seek best execution for its transactions through its affiliated broker. As part of the settlement, the firm and its CEO agreed to pay penalties of $600,000 and $50,000, respectively.[45]

The SEC also brought several cases involving undisclosed revenue sharing agreements. In September, the SEC instituted a litigated administrative proceeding against Houston-based investment advisory firm The Robare Group and its co-owners for failing to disclose a fee arrangement in which the firm received compensation from the broker offering mutual funds the firm recommended to its clients.[46] According to the SEC, the firm began disclosing the arrangement in 2011, but such disclosure was inadequate because it falsely stated that Robare did not receive any economic benefit from a non-client for providing investment advice, and because it stated only that the firm "may" receive compensation when it was in fact receiving such payments. Similarly, the SEC filed a settled action against three principals of a registered investment adviser in November for failing to disclose a conflict of interest and failing to seek to obtain best execution for their clients.[47] The SEC alleged that the principals of Concord Equity Group Advisors entered into an undisclosed arrangement with an executing broker to provide trade execution for Concord’s clients at a commission rate of $0.01 per share executed. However, under the arrangement, the executing broker actually charged Concord’s clients $0.04-$0.06 per share executed, and then paid the amount exceeding $0.01 per share to Concord’s affiliated broker-dealer in the form of a "referral fee." In addition to paying more than $1.5 million in disgorgement and penalties, two of the principals were censured, and the third was suspended from the securities industry for 12 months.

C. Actions Involving Inadequate or Unenforced Compliance Policies

OCIE has reiterated the importance of developing and abiding by effective compliance programs, which the Division of Enforcement emphasizing the point with a large action against Barclay’s Capital. In a September action, the SEC alleged that Barclays had failed to maintain a sufficient internal compliance system following its acquisition of Lehman Brothers’ advisory business in 2008.[48] According to the SEC, while attempting to integrate Lehman’s business, the firm did not enhance its infrastructure to support the acquisition and growth of Lehman’s business and it did not make and keep certain required books and records, resulting in overcharges and client losses of approximately $472,000. Without admitting the allegations, Barclays agreed to pay a $15 million penalty and to retain an independent compliance consultant to remedy internal systems.

One compliance issue continuing to arise in SEC enforcement actions is the custody rule. In late October, the SEC charged private fund manager Sands Brothers Asset Management with violating the custody rule by providing late audited financial statements of its private funds.[49] The custody rule requires advisory firms with custody of client assets to distribute audited financial statements to fund investors within 120 days of the end of the fiscal year, a deadline that Sands Brothers repeatedly missed. Although the SEC did not allege any actual loss of investor assets, it is nonetheless pursuing action against the firm and its two co-founders, as well as its CCO. The SEC’s case appears to have been prompted in part by the repeated nature of the violations, including a 2010 enforcement action against the firm for the same violation. (Several other cases referenced here also included custody rule violations alongside more serious allegations.)

Finally, the SEC brought a number of cases against investment advisers involving everything from misrepresentations to outright misappropriation.

One priority area for OCIE has been misleading performance advertising, and the Division of Enforcement brought several actions involving advisors’ marketing materials.

In the Strategic Capital Group case referenced above, in addition to charges arising from undisclosed principal transactions, the SEC also charged the firm for a pair of false and misleading advertisements.[50] The SEC alleged that that one advertisement failed to disclose that the past performance was based on an index, rather than historical returns achieved by the firm, while another did not disclose that the portrayed results did not deduct fees. In another settled matter filed at the end of the year, the SEC penalized an investment adviser for marketing index products using advertisements stating that returns were based on actual historical trading rather than backtesting.[51]

In another variant of misleading marketing, in July the SEC brought a settled action against Chariot Advisors, manager of an investment company, and its owner, alleging that they falsely claimed that Chariot used an algorithmic model for its currency trading, when in fact the firm had no algorithms capable of engaging in the promised trading.[52] The charges were brought under Section 15(c) of the Investment Company Act, which requires investment company directors to carefully evaluate investment management contracts, and imposes a duty on investment advisers to furnish all reasonably necessary information for the directors to evaluate the contract. The SEC charged that respondents misrepresented their capabilities in gaining approval of their platform from a fund board.

Other SEC actions dealt with what appeared to be much more egregious conduct. In September, the SEC filed a litigated action against a Minneapolis hedge fund manager and his firm, alleging they billed the funds over $1 million for fake research under the auspices of soft dollars.[53] The SEC further alleged that the fund engaged in "portfolio pumping," manipulating the price of a thinly-traded stock that comprised the fund’s largest holding on the last day of each month to artificially inflate the value of the fund portfolio.

Notably, a month earlier, an SEC Administrative Law Judge issued an initial decision in a litigated investment adviser also involving soft dollar abuses (as well as allegations that the adviser had engaged in "cherry-picking," allocating profitable trades to affiliated hedge fund clients to the detriment of other, non-favored clients). The decision found the respondents liable for fraud and other violations, ordering the firm, J.S. Oliver Capital Management, to pay $1.4 million in disgorgement and a civil monetary penalty of approximately $15 million, while ordering its founder and CEO to pay a civil monetary penalty of approximately $3 million and be permanently barred from the industry.[54] A petition for review of the Initial Decision was later granted.[55]

In July, the SEC charged the investment advisory firm Lakeside Capital Management and its owner and portfolio manager with misusing over $8 million in advisory client assets.[56] According to the SEC’s order instituting a settled administrative proceeding, the manager made personal loans to himself from a client portfolio used assets of a private fund, whose investors were nearly all Lakeside clients, to fund personal real estate transactions. The settlement terms included a five year industry bar. And at the end of December, the SEC instituted litigated proceedings proceedings against New York City-based VERO Capital Management and three of its fund managers, alleging that they secretly diverted investor money for their own benefit to bolster a fledgling side business.[57] The SEC claims that after deciding to wind down two funds that had invested primarily in mortgage-backed securities, instead of returning all of the cash to investors as the funds liquidated their investments, the three managers diverted $4.4 million of investor money through undocumented, undisclosed bridge loans to an affiliated company. The managers also allegedly failed to notify clients or to obtain their consent before purchasing three notes worth a total of $7 million from a VERO affiliate, which constituted principal transactions that require notice and consent.

IV. Brokers and Financial Institutions

A. Financial Crisis Cases

The second half of 2014 saw the SEC continue to wind down its efforts to clear out its pipeline of cases arising out of the financial crisis, with a few additional cases involving offerings of residential mortgage-backed securities (RMBS). In July, Morgan Stanley paid a settlement of $275 million in disgorgement and penalties for a pair of RMBS securitizations underwritten by the firm.[58] The SEC alleged that offering documents for the securitizations stated that less than one percent of each pool’s aggregate principal balance was delinquent, when in reality that number was closer to 17 percent. And in August, Bank of America agreed to settle two cases, including a litigated action filed a year earlier, by paying $245 million.[59] According to the SEC, Bank of America failed to inform investors about known uncertainties to future income from its exposure to repurchase claims on mortgage loans during the financial crisis.

In another action in September arising out of the financial downturn, a bank holding company alleged by the SEC to have understated its volume of past due loans agreed to pay $18.5 million in disgorgement.[60]

B. Alternative Trading Systems and High Frequency Trading

As potential issues surrounding alternative trading systems began to capture mainstream public attention in 2014, the SEC brought a number of small cases, establishing what is likely to be a growing area of emphasis for the agency (and, particularly, its specialized Market Abuse unit). In July, the SEC charged LavaFlow Inc., a Citigroup business unit operating an alternative trading system, with failing to protect the confidential trading data of its subscribers.[61] The SEC alleged that LavaFlow allowed an affiliate operating a technology application known as a "smart order router" to access and use confidential information related to the non-displayed orders of LavaFlow’s customers. LavaFlow Inc. agreed to pay $5 million to settle the charges, including a $2.85 penalty, the agency’s largest to date against an alternative trading system.

In October, the SEC charged Athena Capital Research, a high frequency trading firm, with manipulating the closing prices of thousands of NASDAQ-listed stocks by placing a large number of aggressive, rapid-fire trades in the final two seconds of almost every trading day during a six-month period.[62] The SEC alleged that Athena used an algorithm (referred to as "owning the game" in internal emails) that allowed it to drive more than 70% of the total NASDAQ volume for certain securities despite the firm’s relatively small size. Athena agreed to pay a $1 million penalty to settle the charges.

Similar to the actions taken by the Commission, New York Attorney General Eric Schneiderman has focused on both alternative trading platforms and high frequency traders by filing civil fraud charges against Barclays over its private trading platform, alleging that the platform favored high frequency traders over other investors.[63]

C. Market Access Rule

Another area of increasing scrutiny for the SEC is the market access rule, which requires broker-dealers to have adequate risk controls in place before providing customers with access to the markets. In December, the SEC brought a settled action against Morgan Stanley for failing to have adequate risk management controls in place before providing direct market access through its electronic trading desk.[64] According to the SEC, a rogue trader from another firm was able to place orders far in access of his firm’s pre-set aggregate daily trading limit, ultimately leading to a fraudulent trading scheme that put his firm out of business. Without admitting the allegations, Morgan Stanley agreed to pay a $4 million penalty.

A month earlier, the SEC announced a settlement with Wedbush Securities and two former officers of the company, who had been sued by the SEC earlier in 2014 for similar market access rule violations.[65] Wedbush admitted wrongdoing and agreed to retain an independent consultant, while paying a $2.44 million penalty.

D. Hidden Markups

The Commission has also heightened its scrutiny of alleged markups and markdowns of investor trades. In August, the SEC charged New York-based brokerage firm Linkbrokers Derivatives with unlawfully taking secret profits of more than $18 million from customers by adding hidden markups and markdowns to trades. The SEC alleged that Linkbrokers hid the true size of their fees by misrepresenting the prices at which they had executed trades on behalf of their customers. Linkbrokers, which ceased acting as a broker-dealer, agreed to disgorge $14 million.[66] Previously, the SEC had charged four former brokers of Linkbrokers, three of whom agreed to settle for more than $4 million.

In August, the SEC charged the former CEO of a broker-dealer subsidiary of ConvergEx Group with deceiving brokerage customers with hidden fees.[67] The Department of Justice also announced parallel criminal charges against the former CEO. The SEC had previously charged three ConvergEx subsidiaries in the scheme, which settled the matter by agreeing to pay $107 million and admit wrongdoing.

E. Other Broker-Dealer Compliance Cases

Finally, the Commission pursued a number of actions against broker-dealers and financial institutions related to internal controls, net capital, and registration violations in the latter half of the year.

The net capital rule, not often a hotbed of enforcement interest, was the subject of a number of actions in recent months. In September, Latour Trading, a New York high frequency trading firm which at times accounted for 9% of US equity trading volume, agreed to pay $16 million to settle allegations of violating the net capital rule repeatedly over a two-year period.[68] According to the SEC, prior to this case, the highest penalty paid for net capital violations had been $400,000 back in 2004. The SEC alleged that Latour failed to make proper "haircut" deductions to account for market risk, and excluded some positions from taking any haircut deductions at all due to a computer programming error. The SEC also charged the firm’s then-COO, who designed the processing code that facilitated Latour’s haircut calculations, settling with him for $150,000.

The SEC also filed a litigated case against New York broker Crucible Capital Group and its founder, alleging that they not only violated the net capital rule, but provided SEC examiners with doctored invoices in order to conceal the firm’s financial condition.[69] The U.S. Attorney’s Office for the Southern District of New York simultaneously announced criminal charges against the former CEO for obstructing the SEC’s examination. And in yet another case, the SEC instituted settled proceedings against Colorado Financial Service Corporation for net capital rule violations, as well as alleged failures to properly handle customer funds in connection with two private placements in 2010.[70]

In September, the SEC charged Bank of America with violating internal controls and recordkeeping provisions that resulted in regulatory capital overstatements in connection with its assumption of a large portfolio of structured notes as part of its acquisition of Merrill Lynch.[71] Bank of America agreed to pay a $7.65 million penalty to settle the matter, though the SEC press release took unusual steps to commend the bank’s self-reporting of the issue, quick remediation, and cooperation in the investigation.

In October, the SEC charged current and former subsidiaries of E*TRADE Financial Corporation with failing in their gatekeeper roles and improperly engaging in unregistered sales of microcap stocks on behalf of their customers.[72] The SEC alleged that the entities sold billions of penny stock shares for customers during a four-year period while ignoring red flags that the offerings were being conducted without an applicable exemption from the registration provisions of the federal securities laws. The firms agreed to settle by paying more than $1.5 million in disgorgement and prejudgment interest from commissions on improper sales and a combined $1 million penalty.

Finally, the SEC pursued several cases against companies that failed to register with the SEC prior to providing broker-dealer services. In both cases, the SEC noted the importance of registering for the protection of investors. In November, HSBC Private Bank entered into a $12.5 million settlement to resolve allegations that it had failed to register with the SEC before providing cross-border brokerage and investment advisory services to U.S. clients.[73] In December, the SEC sanctioned a computer programmer, Ethan Burnside, who failed to register two online venues that traded securities using virtual currencies, Bitcoin and Litecoin.[74] Without admitting the allegations, Burnside agreed to be barred from the securities industry for two years and to pay a $68,000 penalty, which the SEC noted reflected prompt remedial acts taken by Burnside in cooperation with the SEC’s investigation

V. Insider Trading

A. United States v. Newman

While the latter half of 2014 saw no slowdown in the steady flow of SEC insider trading cases, the government experienced a major judicial setback for its insider trading efforts last month. As we discussed in a recent client alert,[75] in December the United States Court of Appeals for the Second Circuit issued its decision in United States v. Newman, vacating the convictions of insider trading defendants Anthony Chiasson and Todd Newman. In overturning the convictions, the court clarified the law for tipper/tippee insider trading cases and increased the Government’s burden in such cases in two regards. First, the court heightened the requirements for showing a personal benefit sufficient to trigger a breach of a fiduciary duty by the tipper. The Court explained that demonstrating the mere fact of a friendship was insufficient, and that the Government must prove a "meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature." Second, with respect to the liability of a remote or "downstream" tippee, the court held that such a tippee may only be liable for insider trading if he or she had knowledge that the corporate insider provided a tip in exchange for a personal benefit.

The decision is likely to make insider trading charges against remote tippees more difficult to prove in both the criminal and civil contexts. Indeed, the SEC has already moved to dismiss its charges against a downstream tippee accused of profiting from a tip originating with an analyst at Pershing Square, a prominent hedge fund, though the SEC tied its decision to the unavailability of its key witnesses for trial.[76]

B. Misuse of Confidential Information by Investment Professionals

In recent years, the most high-profile insider trading cases brought by the SEC (and often the Department of Justice) involved investment professionals, most notably hedge funds and expert networks. While those cases seemed to drop off in 2014, the SEC did bring several novel actions impacting the securities industry, alleging either insider trading or a lack of controls sufficient to prevent such trades.

In September, the SEC brought a settled proceeding against Wells Fargo Advisors, alleging that the brokerage firm failed to maintain adequate internal controls to prevent insider trading based on a customer’s nonpublic information.[77] According to the SEC, persons within the firm had received indications that one of its brokers (who was ultimately charged with insider trading[78]) was misusing customer information, but failed to act. Wells Fargo Advisors agreed to pay a $5 million penalty, in a case the SEC noted was its first against a broker-dealer for failing to protect a customer’s nonpublic information. In a related proceeding, the SEC initiated a litigated proceeding against a former compliance officer for allegedly altering a trading review document to make it appear she had performed a more thorough review of the trading activity.[79]

Similarly, the SEC brought settled proceedings against a New York broker-dealer and equity research firm for failing to establish and maintain written policies to prevent the misuse of material, nonpublic information.[80] Though that case did not allege any insider trading had occurred, the SEC contended that the firm failed to comply with its own internal procedures regarding the maintenance of restricted lists and reports of personal trading by employees. The firm agreed to pay a $150,000 penalty.

In another novel case, the SEC charged a securities analyst with tipping a coworker at the firm about pending research reports the firm was about to publish. The tips allowed the trader to net nearly $120,000 by trading ahead of upgrades or downgrades in securities.[81] The SEC instituted litigated administrative proceedings against both the tipper (a research analyst at Wells Fargo) and the trader.

Finally, in a case at least peripherally related to the leakage of information about pending disclosures from securities analysts, the SEC brought an unusual insider trading case stemming from activist hedge fund Pershing Square’s negative campaign against Herbalife.[82] In September, the SEC filed a settled action against the roommate of a Pershing Square analyst for allegedly misappropriating information about Pershing’s plans to publicly announce its significant short position in Herbalife. The analyst’s roommate tipped a friend, who bought put options in advance of the announcement. The roommate agreed to pay a penalty of just under $50,000. The tippee who traded was also sued, but, as noted above, the SEC subsequently voluntarily dismissed that case. Notably, in this particular case, the SEC did not specifically allege any wrongdoing by Pershing or its analyst, but the case does raise questions about whether the SEC is focusing greater attention on activist investors who have the ability to move market prices.

One additional area that has not yet resulted in any enforcement actions, but is likely to draw significant attention, is the government’s ongoing investigation into the alleged use of political intelligence by hedge funds.[83] Like the expert network cases previously pursued by the SEC and DOJ, the government appears to be interested in the potential passing of information from lawmakers’ offices to securities industry participants. The investigation is most notable at this point for resulting in a contentious and high-profile battle between the SEC and Congress regarding the SEC’s ability to compel Representatives and their staff members to respond to SEC subpoenas.

C. Misuse of Confidential Information by Other Professionals

The SEC brought several insider trading actions against various professionals accused of abusing their access to clients’ confidential information. In August, the SEC charged an Atlanta-based accountant with insider trading in the stock of a restaurant company based on confidential information he learned from a client who sat on the company’s board of directors.[84] The client had sought tax advice from the accountant in advance of a tender offer announcement. Three of the accountant’s clients were also charged for trading on tips received from the accountant. The accountant and his tippees settled, agreeing to pay disgorgement and penalties without admitting or denying the allegations.

Also in August, the SEC brought a litigated action against an employee of a Manhattan-based investor relations firm, alleging that he repeatedly accessed draft press releases prepared for clients of his firm in order to trade ahead of major announcements, netting nearly $1 million in trading profits.[85] He later pled guilty to parallel criminal charges brought by the DOJ.[86]

And in late December, the SEC brought a settled action against a lawyer at a Southern California law firm who was alleged to have traded on nonpublic information about a client.[87] According to the SEC, the client, a pharmaceutical company, had sought advice from the attorney regarding the disclosure of disappointing sales results, immediately after which both the lawyer and his wife sold all of their stock holdings in the company. Both settled with the SEC, with the attorney agreeing to be suspended from appearing before the agency as a lawyer. And in another law related case, the SEC charged an IT professional at a Palo Alto, California law firm with insider trading ahead of several mergers and acquisitions involving firm clients who were being advised on the deals.[88] The individual was also charged criminally by the DOJ and pled guilty to insider trading.[89]

D. Traditional Insider Trading Cases

Finally, while the latter half of 2014 saw a slowdown in the large, industry-based trading schemes so prevalent in recent years, the SEC continued to roll out a steady stream of cases against corporate insiders accused of trading on information they learned at work or sharing the information with friends.

In a somewhat odd golf-themed trend, the SEC brought two apparently unrelated actions involving sets of friends who golfed at the same country club in Watertown, Massachusetts.[90] In July, the SEC charged seven friends, most of them competitive amateur golfers, with trading in the securities of American Superconductor Corporation based on nonpublic information obtained from a connection at the country club who was an executive at the company.[91] According to the SEC, the company executive shared information about major company developments with a friend, in confidence; the friend then misappropriated the information, sharing it with six friends who traded on multiple occasions. Four of the seven defendants agreed to settle, while the rest are litigating. One month later, the SEC charged a bank executive with tipping a fellow golfer — apparently at the same country club — that his bank was planning to acquire a smaller bank.[92] The friend made nearly $300,000 by investing in the target bank. The executive subsequently pleaded guilty to charges in a parallel criminal case.[93]

In October, the SEC charged a pharmaceutical company financial analyst responsible for evaluating potential acquisitions by the company with tipping his business school friend about upcoming acquisitions, enabling the friend to make over $675,000 in profits.[94] The SEC highlighted the extraordinary steps allegedly taken by the defendants to conceal their conduct, including the use of "burner" cell phones, a shared email account in which draft emails were composed, read, then deleted, and the exchange of a shoebox containing $50,000.

The SEC also filed a number of settled actions against public company executives in November. These included:

an action against the CEO of an engineering and chemical company for divulging inside information about a pending merger to a New York restaurant manager he had befriended;[95]

an action against the COO of a chemical manufacturer alleged to have used accounts held in his children’s names to purchase company shares after he learned it was going to be acquired;[96]

an action against the CEO of a mobile device computing company, for selling off his company shares in advance of a negative earnings report; and[97]

an action against a sales manager at a telecommunications company who learned that his company was about to be awarded a large government contract and tipped a friend; both traded in the securities of the tipper’s company as well as in the securities of the losing bidder for the contract.[98]

Finally, the SEC closed out 2014 by obtaining an emergency asset freeze to protect over $10 million in trading profits. According to the SEC, a director of Santiago, Chile-based CFR Pharmaceuticals traded in the securities of his company (specifically, American depositary shares trading in US markets) after the board began discussing a potential merger with a large American pharmaceutical company.[99] The case is now in litigation.

VI. Municipal Securities

The Enforcement Division’s Municipal Securities and Public Pensions specialized unit brought a small number of high-profile actions in the latter half of the year (in addition to the Puerto Rican bond sweep referenced above).

In August, the SEC brought its third action against a state (following prior cases against New Jersey and Illinois) for their municipal bond disclosures. The SEC alleged that the state of Kansas, in connection with a series of bond offerings through which the state raised $273 million in 2009 and 2010, did not disclose the existence of the significant unfunded liability in the Kansas Public Employees Retirement System, which according to one study at the time, was the second-most underfunded statewide public pension system in the nation. The SEC charged the state with non-scienter violations, and assessed no financial penalties, recognizing in its press release that the state had implemented significant remedial actions to improve its pension liability disclosures.

In November, the SEC brought settled fraud charges against City of Allen Park, Michigan, as well as its former mayor and city administrator, for misleading statements in connection with a $31 million bond offering intended to finance a movie studio project in the city.[100] The SEC alleged that offering documents provided to investors misrepresented the viability of the movie studio project as well as the Detroit suburb’s overall financial condition and its ability to service the bond debt (which represented nearly 10% of the city’s total budget). The two city officials, without admitting the allegations, agreed to be barred from participating in municipal bond offerings. The SEC noted that this was the first time it had charged a city official for "control person" liability under the federal securities laws.

As referenced in our mid-year update, the SEC had taken the extraordinary measure in June of obtaining a temporary restraining order prohibiting the city of Harvey, Illinois and its comptroller from offering or selling any bonds, alleging a scheme to divert proceeds from bond sales for improper, undisclosed purposes. In December, the city agreed to a settlement which included hiring an independent consultant and audit firm, as well as a prohibition from engaging in the offer or sale of any municipal securities for three years unless it retains independent disclosure counsel. The litigation against the former comptroller is ongoing.[101]

One issue to watch going forward will be the impact of the Enforcement Division’s Municipalities Continuing Disclosure Cooperation (MDCC) Initiative, which was announced in March 2014 to incentivize municipal securities issuers and underwriters to self-report to the SEC deficiencies in their compliance with continuing disclosure obligations. The initiative, which was extended in July to allow self-reporting until December 1, 2014, provided capped penalties for those who self-reported.[102] Presumably, the months ahead will provide insight into whether the initiative generated significant responses; if so, the Enforcement Division would no doubt consider extending such initiatives into other areas of the securities laws.

Finally, the SEC announced in August that OCIE was launching a Municipal Advisor Exam Initiative directed at newly regulated municipal advisors required to register with the SEC.[103] A "significant percentage" of advisors will be examined by OCIE and the examinations will focus on "the municipal advisor’s compliance with its fiduciary duty to its municipal entity clients, books and recordkeeping obligations, disclosure, fair dealing, supervision, and employee qualifications and training." The SEC noted that it was working with the MSRB and FINRA to hold a Compliance Outreach Program to educate the newly regulated municipal advisors about the examination process and their legal obligations.

[5] In an August 2014 order approving the SEC’s settlement with Citigroup (following the Second Circuit Court of Appeals’ reversal of the court’s initial rejection of the agreement), Judge Rakoff observed, the "Court of Appeals invites the SEC to avoid even the extremely modest review it leaves to the district court by proceeding on a solely administrative basis… One might wonder: from where does the constitutional warrant for such unchecked and unbalanced administrative power derive?" SEC v. Citigroup Global Markets, 11-cv-7387 (S.D.N.Y. Aug. 5, 2014) at 3 n.8.

[18] See supra, note 14. Harkening back to the above discussion on administrative proceedings, Commissioner Piwowar expressed particular concern about seeking corporate penalties in the administrative forum, where administrative law judges may lack sufficient guidance as to how to set such penalties.

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